Uncertainty

Question 1

What is some examples uncertainty in economics?

Answer 1

• Tomorrow’s prices
• Future wealth
• Actions of people
• Future availability of commodities

Question 2

Give specific examples of how a rational consumer would respond to uncertainty

Answer 2

• Buying insurance (car, health,life)
• Consuming a portfolio of contingent consumption goods

Question 3

Model a car accident as an economic issue

Answer 3

• Car accident (a), if not (na)
• a + na = 1
• If πa occurs (payout of a occurring), the loss is subsequently $L

Question 4

What is state-contingent budget constraints?

Answer 4

• A constraint implemented only when a particular state of nature occurs is state contingent
• i.e. Insurers will only pay if there is an accident

Question 5

What are consumption levels when there is an accident or not an accident?

Answer 5

• Buying $K insurance costs γ means that:
  Ca = m - L - γK +K
  Cna = ([m - γL] / 1 - γ) - γ / (1-γ) * Ca

Question 6

What is the main example of preferences of uncertainty?

Answer 6

• Lotteries
• Expected utilies multiply probability by utilities
• This can also be examined in expected monetary payout
• If E(M) > E(U), you are risk averse

Question 7

What are some examples of utility functions within uncertainty

Answer 7

• Regular: U(c1, c2; π1, π2; 1 - π1 = π2)
• Perfect Substitutes: π1c1 + π2c2
• Cobb-Douglas: C1^π1 * C2^π2 OR π1lnC1 + π2lnC2

Question 8

What are theories and empirical measures of uncertainty (lotteries in particular)?

Answer 8

• Prospect Theory: people value not losing more than winning
• Holt and Laury Test shows us the empirical measurement of lottery